Definition of Derivative securities
Bank of International Settlement outlines the derivate as “a contract whose value be contingent on the price of underlying assets, but which does not need any investment of principal in those assets.”
The derivative security is one of the financial property. It is a financial asset whose value depends on the market price of assets from which they are derived. In other words, derivative security is the evidence of claim or agreement in the form of legal paper which does not possess the real value, but it derives its value from the worth of other assets for which deal is done. So, the value of derivative securities depends on the performance of different underlying assets in the future.
Let’s make it clear with an example: Laxmi went and requested the manager of Nepal Bank to make a contract to purchase 100 shares currently trading at Rs3000 in the Nepal Stock Exchange (NEPSE) within three months. This contract will have worth in future not today as the price of the stock does not remain constant; it fluctuates over time. Say, the price of the stock has increased to Rs.3050 over the period. Now, Laxmi calls for buy the share at the price when the contract was signed. If Laxmi buys and subsequently sells those shares, then she will receive Rs.5000 (100×3050-100×3000). In this case, the deal is the right to claim (buy and sell the assets) in the future, and the share of Nepal Bank is the underlying asset. The value of Rs.5000 is the derived value from the share. Furthermore, Laxmi should make payment a certain amount as an initial margin to make a contract.
Paudel, Baral, Gautam, & Rana, Derivative Market (2017) defined derivative security involves a financial agreement between parties to exchange a standard quantity of the assets or cash flows at a predetermined price at a specified date in the future. The value of derivative securities changes as per change in the value of underlying assets such as stock, bonds, commodities, rates, currencies, index, etc. Through the commodity exchange agreement, parties either take the risk or avoid the risk as per their risk preference.
Common derivative instruments
Options are the type of derivative contract or instrument that provides its holder the right to buy and sell underlying financial assets at some predetermined price within the specified future date. In an option contract, the option writer creates the option and sells this to another party called option holder or owner. The option actually is the choice of the option holder to buy and sell the asset in the future. While taking such an option, the buyer should pay a certain amount to option writer is called the option premium, and such amount is considered as a cost to the buyer at the beginning. Furthermore, the holder may or may not perform the activities depending upon the maker’s condition.
Let’s make it clear with an example: Ms. Moktan gave an option to Mr. Rai to purchase 100 shares of Nabil Bank trading at Rs.4000 per share at NEPSE for four months. In this case, Ms. Moktan is an option creator, and Mr. Rai is an option holder. Say, after four months, the price of the stock increase to Rs.4050 per share in the market. As the market price is higher than the exercising price (strike price), Mr. Rai has advantages to execute the contract and calls to Ms. Moktan on purchasing of share. This option has provided Mr. Rai the right to buy shares and Ms. Moktan to perform her obligation. Instead of it, if the price has decreased to Rs.3950 per share in the market, Mr. Rai has the right to lapse the contract because it has no advantages. (This is the example of buy option)
A call option simply means to right to buy. If a party wants to buy underlying in the future, she/he purchase the call option. So, the call option is a derivative contract that provides a contract holder the right to purchase underlying instruments and make obliged to the writer to sell the assets at a specified price within the stated time. It binds the option creator under the obligation and gives the option holder a choice to buy or not in the future.
Saunders & Cornett, Call options (2015) explained, a call option gives the holder the right to buy underlying at the strike price for this holder should pay a premium to the option creator. The holder of option performs a call option only at a winning position or in the money situation. Generally, the option holder has three cases; in the money, out of the money, and at the money. The wining position, when the contracted price or exercising price is lower than the market price, is in the money. The losing position when the contracted price is higher than the market price is out of the money. The indifferent place, when the contracted amount is equal to the market amount is at the money.
Let’s make it clear with an example: the above example can be taken, Ms. Moktan gave an option to Mr. Rai to purchase 100 of shares of Nabil Bank trading at Rs.4000 per share at NEPSE for four months. Assume, after four months, the price of the stock increase to Rs.4050 per share in the market. As the market price is higher than the exercising price (strike price), Mr. Rai has advantages to execute the contract and claims to Ms. Moktan on purchasing of share. This option has provided Mr. Rai the right to buy shares and Ms. Moktan to perform her obligation. Instead of it, if the price has decreased to Rs.3950 per share in the market, Mr. Rai has the right to lapse the contract because it is not advantageous to him.
Simply, the put option is the right to sell. If a party speculates that the price of the asset will decrease in the future, buy a put option to hedge the risk of loss. So, the put option is also a derivative contract that gives the holder of the option the right to sell the instruments and bound the option writer to purchase the underlying assets at a predetermined price within a specified date. It is merely the right to sell the assets at a specified amount during the stipulated time. Holder executes the option only when the underlying price (market price) is less than the exercising price.
The put option gives the right to the holder to sell the underlying assets at the strike price at a predetermined date. Similar to the call option, the put option has three positions but has the opposite direction. The winning place when the exercising price is higher than the market price is in the money situation. The losing position when contracted price (exercise price) is lower than the market price is out of the money. Indifferent place, when the contracted price is equal to market price is at the money. (Saunders & Cornett, Put options, 2015)
Let’s make it clear with an example: Alisha analyzed the market and speculated the price of the share of standard chartered bank to be declined in the future. So, she bought a put option from Prekshya to sell 100 shares of Standard Chartered trading at Rs.4000 per share after six months. In this case, Alisha is an option buyer or holder, and Prekshya is the option creator. If the speculation turned in reality, and the price of the stock decreased to 3050 per share after six months, Alisha gets the advantage of the contract because exercising price is higher than the market price. Alisha contacts Prekshya and reminds about an agreement to sell the stock. Instead of it, if the price of stock increase to Rs.4050 per share after six months, the contract will not worth her because the market price is higher than the exercise price. Alisha has the right to lapse the deal in this situation.
Besides these two above, options can be of American and European options. American options give their holder the right to buy and sell the underlying assets before and on the expiration date of the contract. But European options give its holder the right to purchase and sell assets only on the expiration date.
The futures contract is a commercial and non-customizable contract where a firm or individual enters into a contract with an exchange, which will act as the intermediary. In broad terms, a futures contract is a standardized contract between parties where one of the parties commits to buying the asset, and another party undertakes to sell the holdings of specified quantity at today’s price in the future. Unlike the option, futures contract binds both parties to buy and sell the underlying assets. Both parties must perform their respective duty as per the agreement. The buyer of the future realizes profit if the future price increase, and the seller of the future realize a gain if future price decrease, but none of the contracting parties have a choice of whether to perform or not to perform the activities. It involves essential elements such as future date (the delivery date or final settlement date of the contract), future price (predetermined price), and underlying assets.
Let’s make it clear with an example: Manjil went to Commodities and Metal Exchange Nepal Limited (COMEN), and requested to enter into the futures contracts to buy one quintal rice trading Rs.50 per kg after three months. In this case, Manjil is the future buyer, and COMEN is the future seller. Regardless of the market condition, after three months, both parties are obliged to perform their duty. Manjil should pay the exercising price to COMEN, and COMEN should deliver the rice as per the contract.
The forward contract is the customizable derivative contract between parties to buy and sell the underlying assets at a predetermined price in the future date. Parties in the forward contract perform their respective obligation by involving in actual buying and selling. So, the forward contracts may or may not require the initial margin to be deposited. A forward contract is more likely to a futures contract, but the forward contract is more personal agreement between parties. Parties directly interact with each other to deliver the assets. So it is also called the over the counter type contract. The forward contract has mostly prevailed in individual level; any assets can be considered as underlying in the forward such as a car, cycle, 20kg rice, &100, pair of shoes, second-hand bike, watch, a goat, orange, etc. Furthermore, forwards are not traded on the centralized exchange, so there is the chance of default of parties of the contract. The parties can customize any terms in the agreement depending upon their requirements.
For example, Ram, a mango farmer, agreed to enter into a contract to sell 100 kg of mango trading Rs.50 per kg with Hari, who exports mango into the market for this season. This contract is made with consideration of both parties, and the price is set with a transparent negotiation. At the harvesting time, Ram should deliver the contracted quantity of mango to Hari, and Hari should pay the exercising price to Ram.
The movement in prices, rates, currencies, indexes, etc. has made something very affordable in one place while expensive in other places or maybe in the same place. So, to make a superior situation, the term Swap has emerged. (Mishkin & Eakins, Swaps, 2018) A defined swap is a contract between two parties to exchange the liabilities of future cash flow or payment from two different financial instruments. The cash involved in swaps usually based on the national principal amount, but instruments may vary. Swap is over the counter type of exchange where parties individually participate in the transaction at the stated time. In the swap agreement, one party agrees to pay the fixed payment on the designated date to a counterparty, which, in turn, decides to make return payments for floating. The main types of Swaps:
Interest rate swaps
Say, Anish borrowed loan at the fixed interest of 10% while Sarada has borrowed in the floating rate of London Interbank Offer Rate (LIBOR) plus 50 points (100 points=1%). Today, LIBOR is 9%, so the floating rate is 9.5%. Later, Anish realized that the floating rate is lower than what he is paying, so he wants to convert into the floating rate. Similarly, Sarada expected the market rate would be increased in the future, so the fixed rate will be beneficial for her. Therefore, they agree to exchange their respective interest liabilities.
Through this example, interest rate swap can be explained as the agreement between two parties to exchange the future interest rate payments based on the specified principal amount of debt instruments at the designated date. The swaps allow parties to transfer their respective interest liabilities to reduce the risk of fluctuation of interest and obtain a lower rate as much as possible. It specifically involves the exchange of the fixed interest rate for the floating interest rate.
It is an agreement to conduct transactions in which parties exchange the equivalent amounts of money with each other but in different currencies. The currency swap involves the exchange of principal amount and interest payments denominated in different currencies. It mainly consists of the exchange fixed or floating rate payments in one currency for fixed or floating payments in a second currency.
Let’s make it clear with an example: Coca Cola the US-based company, wants to launch a new product through a subsidiary, Coca Cola Nepal Limited in Nepal, for that it requires 50 lakhs. If it borrows in Nepal, it should pay a 13% interest rate, but it can get a loan at a 7% per the US. If this company borrows from the US market and sends it to Nepal, there may arise a forex risk. There is also Nepal based Chaudhary Group (CG) Company in the US, which also wants to invest $5 million in the US. If CG borrows in the US, it should pay 8%, but if it borrows in Nepal, it should pay 12%. Both companies do not want to take risks. So, in this case, Coca Cola Company and CG make a swap agreement that Coca Cola Company borrows $5million for two years in US market on behalf of CG at 7% on the other hand CG borrows 50 lakhs for two years in Nepal on behalf of Coca Cola Company at 12%. Both companies get interest benefits. Coca Cola Company pays interest and principal to the lender by taking from the US located CG Company. Similarly, CG pays interest and principal to the lender by taking from Nepal based Coca Cola Company.
Commodity Exchange Market in Nepal
The market where derivative instruments are bought and sold is called the derivative market. The derivative securities such as future, option, swap, warrants, forward, etc. are traded in the derivative market. Firm or individual conducts derivative transaction through over the counter (OTC) or Exchange Company. (Saunders & Cornett, 2015) Defined derivative security markets are the markets in which derivative securities trade. The market in which financial security (such as a futures contract, option contract, swap contract, or mortgage-backed security) traded whose payoff is linked to another, previously issued security such as security traded in the capital or foreign exchange markets.
The derivative market has centuries’ long history. Initially, farmers used to make a deal of price and quantities of the commodities to sell with merchants to avoid loss. More or less, such practices of farmers and merchants introduced the concept of derivatives. The first formal derivative exchange company, Chicago Board of Trade (CBOT), was established in 1848 by a group of merchants to centralize the buying and selling of forwarding contracts. From 1865, CBOT started to list the futures contract. The Chicago Butter and Egg Board, a spin-off of CBOT renamed as Chicago Mercantile Exchange (CME) and allowed future trading in 1919.
The derivative market in India commenced from 2000 after the final approval from the Security Exchange Board of India (SEBI). The derivative transaction started with the S&P CNX Nifty index future in 2000. The trading in index option and option on individual security began in 2001 (The History of Derivative Market in India, 2010). Similarly, the derivative security market in Pakistan began with the trading of OTC derivatives under the State bank of Pakistan in early 2000. In 2002, equity-based derivative traded on Pakistan Stock Exchange (PSX), and in 2007, commodities derivative traded on the Pakistan Mercantile Exchange Limited (PMEX). (Syani, 2017)
The formal derivative market in Nepal has a decade of experience. The derivative market in Nepal has started with the establishment of Commodity and Metal Exchange Nepal Limited (COMEN) in 2063 BS. This exchange company is commenced to help the agriculture sectors of the country. Later, Mercantile Exchange Nepal Ltd (MEX) was also established on August 14, 2007, with comprehensive vision and technology. Similarly, Nepal Derivative Exchange (NDEX) was developed in 2008, considering all the sophisticated needs of traders to provide investment opportunities in derivative securities. Additionally, Wealth Exchange Nepal (WEX), Commodity Future Exchange (CFX), and Everest Commodity Exchange (ECX) were also in operation.
Over a decade, many companies came in operation, and some of them shut down while some of the others are still in operation. Before the implementation of the Commodity Exchange Market Act, 2017, there were three exchange companies operating actively in the past. Derivative and Commodity Exchange Nepal (DCX), Mercantile Exchange Nepal Limited (MEX), and Nepal Derivative Exchange Limited (NDEX) (Old company short-changed by new commodity rules, 2017). May 2; 2018, Nepal Commodities Exchange (NCE) signed the memorandum of understanding (MOU) with derivatives and Commodities Exchange Nepal Ltd. (DCX) and Commodities and Metal Exchange Nepal Ltd (COMEN). It was significant progress to set up a full-fledged regulated exchange (Upadhaya, 2076).
Derivative and Commodity Exchange Nepal (DCX)
November 2011, the Derivative and Commodity Exchange Nepal Ltd. was granted Company recognition by Company Registrar Office, qualifying operating license by the Company Registrar Office of Nepal to operate as a regulated and licensed exchange. It is the multi-product commodity and derivative exchange consisting of options and futures contracts on agriculture, bullion, precious metal, energy, currency, etc.
Mercantile Exchange Nepal Limited (MEX)
MEX was established on August 14, 2007, and started operation from January 5, 2009. It is the first exchange that has introduced the Automated Trading System in the Nepalese Commodity Market. It’s future and spot contract includes precious metal, agriculture commodities, bullion, energy, etc.
Nepal Derivative Exchange Limited (NDEX)
NDEX is a state of the online art commodity and derivative exchange operating in Nepal. It was incorporated on November 20; 2008, under the Companies Act, 2063 of Nepal. It is one of the best and most diverse derivatives exchanges encompassing the broadest range of benchmarked products available such as an agricultural commodity, precious metal, energy, base metal, etc.
Regulation in the derivative market
The Commodity Market in Nepal was operation since 2063 BS without law. Nepal Government issued the Commodity Exchange Market Act, 2017 on August 27; 2072, and Commodity Exchange Market Regulation, 2017 under the Commodity Exchange Market Act under the sub-article (1) of Article 296 of Constitution of Nepal consisting ten Chapters with 64 Sections for the operation and development of the derivative market, for the protection of the interests of investors, for commodities transaction, for clearance and settlement, and the regulation of warehouse operation related businesses. The Government of Nepal decided SEBON as the regulatory body of Derivative Exchanges.
Notice of Registration by Board
After the issuance, Commodity Exchange Market Act, 2017, on November 26, 2017, Board published a notice informing that the interested companies who want to operate the commodity exchange to start the operation only after receiving approval from Board. The currently operating companies were restricted from conducting new deals and should take permission for further action. Five companies (Nepal Commodity Exchange Ltd., Nepal Mercantile Exchange Ltd., Commodity Future Exchange Ltd., Multi Derivative Exchange Ltd., and Rajal Commodity and Derivative Exchange Ltd.) Applied for the pre-approval. Another notice was published on May 1, 2018, mentioning that it has stopped taking application. All corporate bodies found to lack the required certificates and paper, so the Board decided to reject all of them.
Board published the following notice in 12 Baishakh, 2076, appealing all companies who want to operate the commodity market to apply within two months from the publication of the notice. Board has also decided to run only two exchanges considering the size of the economy, development of industrial business, possibilities of tradable commodities, and protection of investor interests, etc. and the selection of companies based on proposed company’s capital and corporate strategy, business planning, proposed technology and capacity to manage and maintain the corporate value. During the deadline, six applications were applied by the derivative exchanges. (Commodity Exchange Market, 2076)
Commodities approved by Board
Products to be listed in the exchanges, prior approval should be made with the SEBON. Schedule 13 of the Commodity Exchange Market Act, 2017, prescribes the list of 53 products and products that can be added by the SEBON. The categories of products:
- Agricultural Production: Cardamom, Cotton, Chili, Cumin, Cashews, Pepper, Betel Nut, Pulses, Red Lentils, Maize, Wheat, Potatoes, Rice Paddy, Fenugreek, Soybean, Mustard, Buckwheat, Flaxseed, Sugarcane, Tobacco, Jute, Ginger, Turmeric, Fruits, and Fruit Juices.
- Precious Metals: Gold, Silver, Platinum
- Metals: Aluminum, Copper, Nickel, Tin, Bronze, Iron, Zinc, Steel
- Oil: Coconut Oil, Mustard Oil, Palm Oil, Sunflower Oil, Soybean Oil, Flaxseed Oil
- Minerals Oils: Crude Oil, Petroleum Products, Natural Gas, Heating Oil
- Others: Sugar, Brown Rock Sugar, Tea, Coffee, Eggs, Herbs
State of market
The market of derivative formally started with a company, COMEN, in 2007. The company used to trade only in imported commodities. Still, there are not more local commodities, but the derivative Board of SEBON is making an effort to list the domestic products. (Pokharel j. , 2016)The defined derivative market as the future market where futures contracts are bought and sold because options and swaps derivatives are still not practiced in Nepal. Nepalese derivative market is in the infant stage, looking around the world, but it is moving slowly. The derivative market is operating with no regulation, and there was no provision of tax on the capital gain of investors initially. Earlier investors who lacked the proper awareness of the market lost their investment, and media released the derivative sector as a risky sector. Furthermore, there is a lack of adequate warehouse for the quality grading of commodities and storage.
The present situation of the Nepalese derivative market can be seen from two facets, i.e., positive and backward. Firstly, let’s consider the positive aspects, though there have been irregularities in past time, Government of Nepal has issued the Commodity Exchange and Market Act, 2017 in 2017 under the control and supervision of SEBON. This Act has its own rules and guidelines for the licensing, operation, commodities, and limitation. The number of commodities listing has increased, including some domestic products. Investors, brokers have gained experience and knowledge of the derivative market over the periods. Media has played a proper role in educating about the commodities markets. Board asked companies to use digital technology and platform. On another side, there is still a lack of financial experts in the derivative market in Nepal. Investors depend on speculation and expect to earn an abnormal profit. There is no security mechanism for investment, as many traders do not even know they are facing loss due to software problems. The derivative market is mainly based on the international product, and the price is set based on the Chicago Mercantile Exchange’s price (directly converted into Nepalese Rupees). Similarly, there is a lack of education on the derivative market among people. Furthermore, it lacks a full-fledged commodity and derivative market with necessary resources, including the required number of commodity derivatives market related to professional and terminal warehouses.
The future and option have a central position in the market. Forward and swaps are also fostering gradually with economic prosperity and infrastructural development. Companies and individuals are participating either as hedger, speculator, or arbitrageurs in the derivative market. In 2076 BS, Board has published the second notice for the licensing to the exchange companies, six exchanges (COMEN, NCE, NDX, Commodity Future Exchange, Rijal Commodity and Derivative Exchange, Multi Derivative Exchange Nepal) applied for the approval. Out of the six companies, which have applied to run the commodity exchange, only two are getting authorization to work in the commodity trading market, said the Executive Director of the Board Niraj Giri. The SEBON has said that two commodity exchange company would come into operation soon. (Licence to two commodity exchange soon: SEBON, 2019)The challenges and problems in the development and improvements of the derivative market in Nepal mentioned in the annual report of the Security Board of 2075/2076:
- There is a lack of law structure regarding the warehouse for the development of the derivative market, so this is one of the challenges of the stable growth of the derivative market.
- It would be a challenging job to make the derivative market as competitive and trustworthy, maintain the quality grading mechanism, establish payment funds, and manage improved transaction systems like other markets in the economy.
- As per the commodity exchange market law and regulation, it is a challenging task to prepare the base of licensing and facilitating to commercial and competitive companies and subsequently operating the competitive one.
- SEBON is responsible for controlling commodity exchanges; it would be a challenge to manage and operate the market, maintain effective exchange, develop warehouse and infrastructure of market, increasing the general awareness among people and associate the market with local commodities and considered it as a useful means to improve the country’s economy.
In a nutshell, Derivatives securities are the financial instruments that derive their value from the value of other underlying assets. Parties involved in the derivative market through future, option, forward, swaps, etc. for hedging or speculative purpose. The option contract provides the right to the holder to buy and sell the underlying through Put and Call options. An option contract binds the writer of the contract to perform the activities. But the future contract binds both parties to perform their respective obligations. The futures contract is the standardized contract to buy and sell underlying such as shares, currencies, indexes, etc. While forward contra is a customizable contract between parties. This contract is more private as parties directly interact with each other. Anything can be considered as underlying in the forward contract such a: t-shirt, 10 kg rice, bicycle, share, etc. but only listed assets can be contracted in the future contracts. Swaps are the contract between two parties to exchange the liabilities of future cash flow or payment from two different financial instruments. It includes various forms such as the interest rate swap (exchange the interest payment), a currency swap (exchange both principal and interest), the credit default swap, a commodity swap, etc.
The practice of the derivative market in Nepal has started in the form of a forward contract since long back. Officially COMEN was established in 2063 BS and started the derivative market. Though it has crossed a decade, the commodity market is still in the developing stage. Many companies were formed, and some of them were shut down over the period. Government of Nepal issued Commodity Exchange Market Act, 2017, in 2017. Since 2017, the Government has started to interfere in the derivative market. SEBON declared to be the regulatory body of the Derivative exchanges. The Board issued a notice regarding the registration under SEBON to operate the derivative exchange for both currently operating and proposing to operate the derivative company. The current company asked to restrict themselves to make a new contract. Five applications were applied by the corporate body, but all of them were not able to meet the requirement, and all were rejected. In the second notice, six applications were applied by companies, and the Board has decided to select only two of them.
During this period, companies, clients, and brokers have faced different situations, and they also have gained something from it. Furthermore, the enforcement of the Act has made us optimistic about the derivative market. The awareness of the derivative market and securities increases as brokers and exchange companies are regularly providing training and seminars. The Government is also making an effort to promote the derivative market. But, the saddest part is the strike of widely pandemic and lockdown which, is becoming the hurdle to continue the proposed work.